Duck Lake Diner is considering replacing its old milk-shake machine with a newer

Question

Duck Lake Diner is considering replacing its old milk-shake machine with a newer one. The old milk-shake machine is currently worth $1000 and is being depreciated to zero. It was purchased 5 years ago for $2665 and was being depreciated on a straight line basis over its original 8 year life to zero. The new milk- shake machine would cost $2,500. It is being depreciated on a straight line basis over three years to its expected salvage value of $1,200. Both machines require the same upkeep. In three years, the Diner will be closed when traffic is rerouted onto a new highway. The old machine could be sold for $250 at the end of three years. The tax rate is 40%. If Duck Lake Diner’s opportunity cost of capital is 15%, should Duck Lake Diner replace the milk shake machine? Show your workings.

Explanation / Answer

Decistion situation: whether old milk shake with a newer one:

Decsion: if the old machine is replaced by new machine, the present value incrmental cash outflow increased by $810, so Duck Lake Diner better to continue with old machine for further 3 years.

*Note; Market value of the old machine after 3 years = $250

(-) Book Value = 0

Capital gain = $250

(-) Tax 40% = $100

Net Proceed from old machine = $150

1)Old milkshate 2)newer Milk shake 3)incremtnal 4)PVF@15% 3x4=5)Present Value 1) Initial Cash outflows $1,000 $2,500 $1,500 1 $1,500 2) Terminal cash inflows at 3rd year *$150 $1,200 $1,050 0.657 $ 690 3) present value of Incremntal cash flows (1-2) $810

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